Intelligent Energy Holdings — Update 11 November 2015

In February 2015, IEH announced that it had reached agreement in principle with GTL, a provider of services and infrastructure to the Indian telecommunications sector, with regard to the long-term power management rights over a 26,000 telecom tower estate in India. The number of towers under management increased from around 10,000, the majority of which were already managed under an interim agreement with GTL, to around 27,000. On 1 October, IEH announced that the agreement with GTL to acquire the energy management business had at last been signed. The consideration payable is INR850 Crores (£85m), of which up to £25m will be financed by IEH and up to INR600 Crores (£60m) from debt funding secured against the revenue streams of the Energy Management Business. The consideration is payable on completion, which is likely to take place in CY Q116. Until completion, energy management of the towers will be conducted under the interim agreement at minimal EBITDA margins.

This is a transformative deal for IEH. It is expected to have a material impact on profitability. The majority of the Group’s revenues are currently derived from the DP&G division. As noted above, at present most of the towers under management are operated under an interim contract with GTL. Under the interim contract, the towers are operated at minimal EBITDA margin, but once this long-term contract is completed, EBITDA margin is expected to increase to 15% initially. Over three to five years, management expects to be able to increase EBITDA margin to around 30-35%. This will be achieved by improving the efficiency of sites, by replacing worn-out diesel generators with fuel cells where economic and by generating surplus electricity for sale to third parties for applications such as water purification (see our initiation note, pages 6 and 7 for details of how margin expansion will be achieved). IEH expects annual revenues from providing power and maintaining equipment to be around £120m per year.

The transaction is also valuable strategically as it provides a platform to deploy fuel cells incorporating IEH technology. Management estimates that around 70% of sites currently under management experience power outages of more than eight hours a day and are therefore suitable candidates for substituting fuel cells for diesel generators as the latter wear out, resulting in wide-scale deployment over the next three to five years. Smaller volumes of fuel cells would be manufactured on the ready-to-scale line built by the JV between IEH and Suzuki. Larger volumes will probably be manufactured locally by third parties in India. We note that IEH is considering selling part of its Indian business (this is discussed in the section on cash flow). If this happens, the strategic ambition to create a platform to deploy fuel cells that is independent of widespread adoption in the automotive industry will still be fulfilled.

Additionally, the transaction creates a blueprint for further deals of this type. GTL’s tower estate represents an estimated 7% of towers in India, so there is plenty of scope to increase the number of towers under management. IEH continues to hold discussions with other parties interested in a similar arrangement. Once the GTL agreement is completed, it is likely that other agreements will follow. Our financial model assumes one other deal similar in size to GTL completing by the end of FY16.

Management has identified an opportunity to improve the profitability of the energy management operation yet further by acquiring IP (know-how, operational processes and services) that improve performance and reduce downtime. This IP would also make it easier for IEH to expand its energy management operations elsewhere in South-East Asia and increase the attractiveness of IEH’s energy management proposition. Management expects that the consideration payable, if the acquisition proceeds, will be £30-45m. This would be funded by non-recourse debt finance, financed by charges payable by the Indian energy management business for access to the IP and covered by the resultant margin improvement.

Our previous estimates had assumed that the GTL contract would complete by mid-FY15. The delay in completing the contract has a negative impact on FY15 forecasts, as the average revenue generated per site under the interim contract is less, and generates a minimal EBITDA margin. As management has been focused on finalising the GTL agreement, discussions with other parties have not been concluded, so the total number of towers under management added during the year has not been as great as we originally modelled. Therefore, this has a negative impact on FY15 divisional performance. We expect some of the discussions with other parties to complete during H216, so the number of towers added in our model during FY16 remains unchanged. However, for the first part of the year the GTL towers under management will generate lower revenues and EBITDA margins than previously assumed.

The recent trading statement notes that, because of the phasing of some JDA activity from H215 to H116, the division is expected to show a year-on-year reduction in revenues during FY15. We adjust our FY15 estimates to reflect this. Our FY16 estimates remain unchanged, underpinned by the recent announcement of an extension to the development programme with the existing Asian OEMs, which is worth c £6.5m over two and a half years, and the EU-backed VolumetriQ programme. This is a three-year programme, supported by €5m of funding, with a target to develop fuel cell stack based on IEH’s proprietary 90kW fuel cell technology that can be manufactured in high volumes for use in hydrogen fuel cell vehicles by 2020. IEH is leading the programme. The industrial partners include Johnson Matthey Fuel Cells, Solway Speciality Polymers and automotive component OEM ElringKlinger. BMW Group and Daimler will be participating by setting out the stack requirements.

Our estimates model the award of a major licence deal in FY17. While it is not possible to predict with certainty when major licence deals will be awarded, external events make an award seem more likely. Recent months have seen a surge in activity related to fuel cell vehicles. For example, in September, the first public access hydrogen refuelling station was launched at the Advanced Manufacturing Park, just off Junction 33 of the M1 in South Yorkshire. This is a significant advance in creating a viable infrastructure to support adoption of fuel cell vehicles in the UK. It is particularly timely given that Toyota launched its new Mirai hydrogen fuel cell vehicle in the UK during October. Those automotive manufacturers that have not already developed their own fuel cell technology have limited options. The high-cost (estimated at several billion dollars) and lengthy time-scales to develop the technology in-house make licensing the technology a good option. IEH is the only independent provider of technology suitable for a wide range of vehicles. BMW and Daimler’s participation in the VolumetriQ programme, intended to develop a robust, high-volume variant of IEH’s current automotive product, illustrates the high levels of interest in the technology.

The Upp device, which is an external fuel cell charger for mobile phones, was launched in Apple stores in November 2014. Adoption has been limited, probably because of the high cost of refills (£149 for fuel cell and initial cartridge, £5.95 for refill cartridges) and weight of the combined charger and fuel capsule. We adjust our divisional estimates so that ramp-up in volumes associated with the availability of the lighter disposable refills is delayed until FY17. We reduce the divisional operating costs, assuming that marketing expenditure will be minimal until the disposable cartridges are launched. The acquisition of fuel cell-related assets from Societe BIC in February 2015 is key to the development of the disposable fuel cartridges. Integrating these assets is progressing well.

From a strategic stance, the Upp should be regarded as a stepping stone to creating a fuel cell that is fully embedded in a mobile device. In August IEH demonstrated its fuel cell technologies embedded in cell phone and tablet hardware without reducing any of the functionality or battery life of the devices. It has also demonstrated consumer electronics derived technology to a potential industrial partner in an adjacent fast-growth market. We exclude any contribution from this project from our estimates.

We expect the reduction in DP&G revenues and profitability resulting from the delays in completing the GTL contract to have a material impact on Group revenue forecasts during FY15 and FY16. The impact on profitability has been mitigated by management’s actions in reducing the central cost base, modelled at £31.3m for FY15 compared with £38.4m in FY14. Our revised model assumes that IEH acquires energy management rights but not the tangible assets, reducing depreciation charges and thus loss before tax in FY15. The net cash position at the end of FY15, stated by management as £24.5m, is better than expected because of the delay in acquiring the GTL energy management business. The estimates for net debt at the end of FY16 and FY17 are higher than previously because we now model a higher average cost of acquisition for each site.

Our estimates model £85m cash outflow associated with the acquisition of the GTL energy management business and a further £93m associated with the acquisition of energy management rights for a further 30,000 telecom towers. This is included within capex. £60m of GTL acquisition cost is expected to be funded by debt funding secured against the revenue streams of the Energy Management Business. This is included in long-term borrowings. We expect that all the funding needed to acquire the additional 30,000 telecom towers will be provided under a similar arrangement. This leaves an estimated £65m funding gap, which we model as provided by short-term debt.

Management is currently exploring two complementary options to bridge this funding gap. The first involves a proposed issue of a convertible instrument to industrial partners. The terms have not yet been agreed but are expected to include a strike price that is at a premium to the current share price. The second involves realisation of value from the Indian operations. We have not modelled the impact of either of these potential initiatives, but note that either would remove the potential for a discounted funding round and associated dilution, a prospect that has weighed down the share price.

Our analysis now focuses on the year ended September 2017, rather than September 2016, as delays in signing the GTL contract mean that the later period is more representative of the potential revenues that may be generated from the DP&G division. Noting the recent announcements relating to the Motive division, which strengthen the likelihood of a licence deal, we now value this division separately from the Consumer Electronics division. Our previous note used the same methodology for both the Consumer Electronics and Motive divisions.

Our analysis of a sample of listed peers engaged in the provision of power generation and other equipment to utilities and the construction sector indicates that a calendarised EV/Sales ratio of 2.0x for the twelve months ending September 2017 is appropriate. We apply this multiple to a range of revenues extending from our base case for FY17e (£320.1m divisional revenues) to FY17e revenues realisable if a more rapid growth trajectory enables management to achieve its ambitious target of 135k telecoms towers under management by the end of FY17 (£592.0m divisional revenues). Although we would normally state EV by reference to historic net debt or cash (and this is the basis of EV/sales ratio for the peer group), in the case of IEH we have used net cash as forecast for September 2015, and have adjusted this figure for prospective expansion investment, as this amount is particularly material.

Noting the uncertainty regarding the revenue structure of any future deals with telecom tower operators, we apply a 30% discount for current perceived levels of risk. This gives an indicative value of between £291m (base case as modelled in our estimates) and £670m. This upper end of the range rises to £957m if no risk adjustment is applied. We note that the base case indicative value for this division on its own is 59% higher than the current market capitalisation.

We adopt a similar process to determine the incremental value associated with the Consumer Electronics division. This time we apply the calendarised EV/Sales multiple for the twelve months ended September 2017 (2.4x) derived from a sample of listed companies involved in fuel cell development to our divisional FY17e revenue estimate. (Noting that one of AFC Energy’s fuel cell systems has recently delivered power to the German grid, we recognise that the company has progressed sufficiently towards commercialisation to be included in the list of peers.) Applying a 30% discount for current perceived levels of executional risk, gives divisional indicative value of £31m, which is our base case. The risk-free indicative value is £44m. This analysis excludes any potential licence or royalty revenues generated by the division as it is likely that these will occur outside the period covered by our estimates. Note: In this analysis, all the debt is attributed to the DP&G division.

The business model for the Motive division differs from the other two divisions, in that we expect substantial income from licence fees during the period covered by our estimates. These attract substantially higher margins than revenues from supplying managed power services or product sales.

We therefore apply a calendarised EV/EBITDA multiple for the twelve months ending September 2017 (13.5x) to FY17e divisional EBITDA. A single licence fee similar to that previously received from Suzuki would be £45m. Our estimates attribute the entire £45m to FY17. For valuation purposes, we assume that the Motive division will receive a sizeable licence fee (c £45m) every three years, and therefore ascribe one-third of the licence fee (£15m) to our FY17e in the valuation calculation shown in Exhibit 7. Applying a 25% discount for current perceived levels of executional risk gives a divisional indicative value of £149m, which is our base-case. (We apply a lower discount for risk to the Motive division because recent announcements demonstrate strengthening customer engagement, increasing the likelihood of one or more licence deals in future.) The divisional risk-free indicative value is £199m. This analysis excludes any potential royalty revenues generated by the division as it is likely that these will occur outside the period covered by our estimates. As discussed previously, all the debt is attributed to the DP&G division.

Summing the indicative valuations for the three divisions gives a base-case of £471m and an upper bound of £1,200m. This is derived from the risk-free indicative values, assuming that the DP&G division reaches management’s ambitious target of 135k sites under management by the end of FY17. This analysis excludes any value associated with long-term royalties for the Motive division or licence fees and royalties for the Consumer Electronics divisions.